Convex Investments and the Government’s Debt Problem

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• Fewer bond buyers could threaten an overleveraged financial system. From this perspective, a global recession would benefit central banks.
• A convex investment strategy profits from long volatility. Dave Dredge argues the merits of convex portfolios using a historical example and the current global economic climate.
• Japan in particular is positioned to dramatically influence global markets as its private sector withdraws from foreign investments.

After a booming 2023 for equity markets, is it safe to say we’ve avoided a global recession? Economists have growing optimism for the eurozone, Japanese stocks are rising and the U.S. Federal Reserve shows signs of its so-called soft landing and the return to a Goldilocks scenario — a cooling of inflation without a disruption to economic growth.

Yet for the long-term stability of the global fixed-income market, a recession may be welcome news. This is the viewpoint of Dave Dredge, Chief Investment Officer at Convex Strategies, a Singapore-based alternative investment allocator specializing in risk management.

As governments borrow to cover their deficits and promise higher interest rates in return, the financial system faces a grave problem if not enough buyers step in to back the treasuries. For Dave, the systemic risk to the fixed-income market is most easily resolved if the global economy cools. “A good outcome is going to be a recession,” he says, “because in a recession, people will buy the bonds.”

One year ago, Dave spoke about the end of 60/40 portfolios and the central banks’ unspoken prayer for a recession that will save them from a capital drought. Now, as we look ahead into 2024, the alarm bells are ringing louder as foreign buyers for U.S. Treasury bonds disappear. What’s been celebrated as a soft landing may be the start of years of stagflation.

In Dave’s return to Top Traders Unplugged, Cem Karsan and I asked him about his outlook on global volatility, the cracks in the banking system and how investors should respond. Dave explained the scenarios that compound portfolio convexity, risk management with structured products and the dangers of short-volatility trades. It starts with a question: Is the current rosy assessment of the global economy too good to be true?

Unmasking Goldilocks

In December 2023, Federal Reserve Chair Jerome Powell reiterated the idea that the U.S. was on track for a soft landing, forecasting that inflation could come down without a significant impact on the job market. This is the Goldilocks economy — not too hot, not too cold.

So far this seems to be the narrative. U.S. inflation is trending lower and, despite some high-profile tech industry layoffs in 2023, U.S. unemployment as a whole was at 3.7% in December per the Bureau of Labor Statistics. But as the story goes, while Goldilocks is enjoying her porridge, the bears are on their way home.

“​​That’s the perception right now, that we have the best of both worlds,” says Cem, referring to low inflation and economic growth. “The interesting thing is, not too far away from the best of both things is the worst of both things.”

That worst of both worlds is the dreaded stagflation — persistent high inflation rates combined with high unemployment and an economic slowdown. For decades, loose monetary policies stimulated the economy with near-zero interest rates as increased globalization and other macroeconomic factors created deflationary pressure. Now, demand shocks, supply chain woes and a push for deglobalization have created a tailwind for rising prices.

“Right now there's a structural inflationary pressure from the rebalancing of inequality and the political pressures that are driving it, and we're having to manage a much more difficult situation,” Cem notes.

With eyes on consumer price indices and the job market, another global economic risk has escaped attention. Namely, the global financial system may be overleveraged. The sudden March 2023 Silicon Valley Bank collapse exposed the fragility of the financial system. More meltdowns could come if there isn’t sufficient capital to support the leverage in financial institutions. A source of that mismatch is not having enough buyers of bonds.

The public debt problem

Bonds are a primary means for federal governments to resolve their debts, and generally the system is a win-win. Governments can cover their expenditures without raising taxes, and creditors collect interest at effectively zero risk.

But after several years of heavy spending through pandemic stimulus and government subsidies of food and energy costs, central banks may have more debt than creditors are willing to buy. The U.S. Treasury alone is expected to issue nearly $2 trillion in bonds this year, which would be close to double the issuance of 2023.

“The regulated financial system is allowed to treat government bonds somewhere between riskless and risk-reducing,” Dave explains. “That’s what causes the system to creak.”

It’s a supply and demand problem. When there isn’t sufficient demand for government-issued debt, there’s an overabundance and the price of bonds drops. This isn’t inherently bad, but if banks are overexposed to long-term bonds, they could be forced to sell at a loss when too many depositors request a withdrawal. Insurance companies, pensions and wealth management funds face a similar problem with falling bond prices creating an unrealized loss, which, when called, can cause a meltdown in the financial system.

Immaculate recession

Enter what Dave calls “the immaculate recession.” If the stock market sinks and more money moves to bonds — or if interest rates drop, which would drive the price up on the higher existing coupon rates — the demand for bonds will increase and release the pressure on the financial system.

Dave also points to the declining lending in the U.S. banking system. “The regional banking system has been incentivized to hold on to their treasuries that they can [repossess] at face value and not make any loans to anybody else,” he says. In other words, if your only choices are to sell a bond at a loss in order to make a loan or keep the bond until maturity, it’s in smaller banks’ best interests not to loan any money. This is where the economy can stagnate.

Were a recession to resolve that tension, however, banks would be in a better position to increase lending, but of course loan demand typically decreases during an economic downturn. So prayers go up that it will indeed be an immaculate recession, one seemingly divine in how it can both save the bond market and keep a steady flow of loan applications in the banking system. It’s a thin line to walk with fields of chaos on either side.

To put this in market terms, Dave says, “Volatility and liquidity are just opposite sides of the same coin.” If there isn’t enough liquidity in the financial system, volatility will spike in a crash. This is where convexity does well — a convex investment strategy is one designed to outperform benchmarks in extreme scenarios. Given enough time, extreme is an inevitability.

Entropy wins

Dave quotes the 20th century economist Hyman Minsky: “Stability begets instability.” If the Fed’s soft landing is a stabilizing moment, volatility is likely to follow. Dave offers the analogy of a soccer game.

“In a [soccer] match,” he says, “96% of the time, the ball spends 96% of the time in between the two penalty boxes. Only 2% of the time does it spend inside [each of the] two penalty boxes, but the entire outcome of the match is determined inside [those] penalty boxes.”

It’s a long game of tactics, positioning and strategy, but a few seconds of brilliance is all it takes to put the ball in the back of the net and win the match. When it comes to investing, the deciding goal is either a market boom or bust. As any trader knows, extreme price events happen quickly but their impact can be long-lasting.

Sharpe ratios — a measure of investment risk — are often used to remove volatility from a strategy. Investors gravitate toward the relative safety of measuring average performance from the middle of the metaphorical soccer field instead of trying to score a goal. “We’re all taught to ignore the two-percentile weeks [when markets are at their extremes] and focus on the expected center of the outcome,” Dave says.

Dave’s counterargument to this approach is that, over a 40-year period of the S&P 500, the extremes are what drove the returns. “The ten worst months contributed a little over 40% of the return, and the ten best months contributed a little over 30% of the return,” he explained. In other words, 70% of the total return came in just 4% of the time period. A convex investment strategy optimized for those extremes, rather than one optimized for the middle ground, would have done quite well.

An American case study

What does extreme volatility look like in action? Of course the COVID pandemic comes to mind, but another period of U.S. history is a strong illustration of Dave’s argument.

For all of its horrors, the chaos of World War II was a tremendous boost for the U.S. economy. “Private sector debt in the U.S. [during the Great Depression] went to zero. And then you had four to five years of austerity, as the only borrower in the system was the government to fund a war,” Dave explains.

Wartime production and heavy government spending were largely responsible for pulling America out of the Great Depression. For the most part, consumers weren’t holding loans pre-WWII — no car payments, credit card bills or home mortgages back then — so the influx of economic stimulation helped the middle class build wealth. The war’s sudden impact on the government’s monetary policy had lasting economic effects.

Japan in focus

The present-day economy that most reminds Dave of post-WWII America is Japan. The Pacific nation’s ultra-loose monetary policy with negative interest rates was intended to encourage lending and consumer spending. As a result of the low rates, the Japanese private sector carries little debt. Meanwhile, the yen has dropped steadily in the last several years as Japan broke the trend of other central banks by not raising rates, leading many Japanese investors to foreign markets with better fixed income performance.

As the Bank of Japan now considers some policy reversal, along with its heavy purchasing of its own government bonds, domestic opportunities may seem more attractive to Japanese institutional investors. This could bring money back to Japan — already the world’s third-largest economy by GDP — and remove liquidity from other bond markets, exacerbating the global demand problem even further. And, as was the case with post-WWII Americans, most Japanese consumers aren’t carrying heavy personal debts, so an economic boom will reinvest quickly into industry and innovation.

“Japan is the most dangerous peg in the world,” Dave says. “What does it mean when the whole [Japanese] private sector — [which] has been the largest net foreign investor and foreign creditor ever — says, Jeez, our opportunities are better now back home?” It’s yet another sign that volatility could soon ripple through financial markets.

The case for convexity

With the philosophy understood, how does one make a convex portfolio? Dave’s Convex Strategies fund looks for asymmetry in options and structured products to find those volatility extremes before they’re realized in the market. Put another way, they look for cracks in the system and position for when it breaks.

Dave says, “We’re not trying to project a probability distribution; we’re trying to project a possibility distribution. We’re trying to measure that entropy outside the probabilistic.” Remember, those winning trades might only happen 4% of the time, but it’s a massive return when they do.

It’s not a strategy easily replicated by retail investors. Although some financial institutions allow retail investors to short volatility through trades that often have negative asymmetric returns, Dave reports the inverse — long volatility, positive asymmetric — is hard to find. He suggests considering a risk management firm with access to these strategies. Investors should remain open to the possibility that unrealized losses in the banking system are far from over and the implications of that system pressure could have unexpected results.

“The markets will forever fool you,” Dave says. The wise investor plans for volatility.

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This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.